News & Views

Why is strategic asset allocation at pension funds not as robust as at other financial institutions?

The approach to strategic asset allocation at pension funds starts with the trustees setting a return requirement that, after taking account of the sponsor’s contributions, will achieve full funding within some defined time horizon.  At the same time they will consider their risk tolerance and set risk constraints for the fund.  Armed with their return and risk objectives they then rely on their investment consultant’s asset liability model to produce a range of possible portfolios that will achieve the required return objective within the risk constraint.  Further analysis will then be completed to refine the suggested portfolio.  The approach appears robust and gives trustees confidence in their strategic asset allocation.

Contrast this with the approach generally taken by banks when placing their capital at risk.  Again they will have a clearly defined return objective and risk constraints.  However, in the banks case they will rely on the output from several different risk models before deciding on their portfolio benchmark.

By using a number of different risk models, banks are able to minimise the impact of model risk, the risk that a model is subsequently found to have not been performing correctly.  Most of the time the models will give similar results.  However, when they differ, the bank is able to challenge the risk model methodology and assumptions to understand what is driving the differences and adjust their decision making accordingly.

Pension funds, relying on a single asset liability model, do not have the same opportunity as banks.  The reliance of most schemes on a single investment consultant firm mitigates against an alternative view.  Even if trustees did wish to seek an alternative asset liability study, the cost of this is prohibitively expensive for all but the largest schemes. Without access to the output from alternative risk models, trustees find it difficult to challenge the asset liability study information produced by the consultant.

Given the importance of the strategic asset allocation decision this reliance on the risk modeling from a single firm leaves a gap in the governance of a pension scheme in a critical area.  New approaches to risk model oversight, such as the Asset Liability Model Monitor service, now make it possible for trustees to identify any anomalies in their consultant’s asset liability model in a cost effective way.  As a result, they are able to effectively challenge the information provided to them by their consultant, with consequent benefits to their investment decision making and scheme governance.

Asset liability models sit at the heart of investment decision making at most pension funds.  This is particularly true when trustees are determining the strategic asset allocation for the fund, the most important investment decision for any pension fund.  However, unlike financial organisations that will typically consider the output from several different risk models before they put their capital at risk, pension funds base their decisions on the output from a single risk model.

NULL